In this series "What is actually ...?", Oliver Völkel explains various terms and concepts relating to blockchain and distributed ledger technology (DLT). This article is again dedicated to a fundamental concept, namely the concept of tokenization.
Tokenization is the process of creating a digital representation of an asset in the form of tokens on a blockchain. Tokenization has two main objectives: Firstly, it aims to reduce or avoid intermediaries (e.g., paying agents and custodians). Secondly, it aims to increase the liquidity of the tokenized asset (e.g., gold or immovable property). Tokens are, after all, easier to transfer than a gold coin, for example.
Both tangible and intangible assets can be linked to tokens. Examples of tangible assets are gold, real estate and works of art. Intangible assets mainly include debt or equity obligations such as financial instruments (shares, bonds, units in funds) and intellectual property rights (such as certain NFTs).
The core of tokenization is the legal link between the asset and the token. How this link is established depends on the legal relationship between the issuer and the holder of the token as well as the asset in question.
Blockchain is a digital ledger that records transaction data. The record is often referred to as "permanent" or "immutable" because the cryptographic functions on which blockchain technology is based make it virtually impossible to change the transaction history without this being immediately apparent to other participants in the network. Most public blockchains such as Bitcoin and Ethereum are decentralized. The record of transactions is therefore managed in real time by a large number of nodes in a peer-to-peer network and not by a central body (e.g., a bank).
In their basic form, simple blockchain transactions contain an origin, destination and a specific value, such as the amount of tokens that are transferred. The origin and destination are referred to as addresses, which are basically long alphanumeric strings that are generated according to certain mathematical rules and represent the sender and recipient of the transaction. When a new address is created, a second alphanumeric string is generated that is unique for this address (the private key). Only one such private key is assigned to each address. The private key is required for the authentication of transactions. The address and private key are also referred to as a wallet, regardless of the technical implementation. A hardware wallet stores the address and private key on a physical electronic device, a paper wallet stores this information on a piece of paper or plastic, a hot wallet is software connected to the Internet, while a cold wallet does not require such a connection.
Before a transaction becomes part of the blockchain, a transaction request must be sent to the network, which is verified and confirmed by the nodes in the peer-to-peer network that operates the blockchain. Transaction requests are confirmed by the nodes if they are properly signed by the sender and the transaction request does not violate the rules of the consensus mechanism (e.g., no double transfer of tokens). Transaction requests are not confirmed on an individual basis, but en bloc for several transaction requests. This means that several transaction requests are confirmed at the same time. All confirmed transaction requests are permanently stored in the blockchain. This process continuously expands the transaction history block by block. The participants who propose and verify blocks are called miners (in the case of proof-of-work) or validators (in the case of proof-of-stake). Miners and validators within the same network are independent of one other; there is no legal relationship between them.
Anyone who submits a transaction request promises a reward to the miner or validator who records the transaction in a block. This is also known as a "transaction fee". The transaction fee is an economic incentive for miners and validators to confirm transactions. If more transaction requests are made than can be recorded in a single block, the transaction fee is a mechanism for prioritizing the transaction requests. The higher the transaction fee, the more likely it is that this transaction will be quickly recorded in a block. The transaction fee is the promise of a reward, not directed to a specific person, for bringing about a specific success (namely the confirmation of a transaction request in a block).
In addition to the permanent storage of confirmed transactions and the verification of new transaction requests, blockchains such as Ethereum enable the decentralized execution of computer programs, also known as smart contracts. Tokenization requires the use of smart contracts. Smart contracts perform certain tasks automatically based on their programming. Both the program code itself and all changes made by a smart contract are permanently stored on the blockchain. As a rule, a smart contract is based on a specific technical standard, such as the ERC-1155 standard. Smart contracts can be used to create an unlimited number of tokens. When creating the tokens, the respective smart contract simply records the desired number of tokens (in the case of fungible tokens) on a specific address.
The transfer of tokens from one person to another is carried out by the associated smart contract. If the smart contract is programmed to require a potential recipient to be whitelisted beforehand, and if the contractual terms of the (financial) instrument contain a clause that only allows transfer to a whitelisted party, this would allow the issuer to link the addresses used to the names of the holders (in its own database; not necessarily publicly on the blockchain); the issuer could then determine at any time which person is the current holder of the instrument.
Smart contracts can be provided with certain other features, such as suspending the transfer of tokens (freezing) or restricting access to tokens and the ability to transfer them only to certain whitelisted individuals (as described above). The implementation of functions in the smart contract that restrict the free transferability of tokens or introduce options for changing the stored data has legal implications.
Tokenization generally takes place in two steps: First, tokens are created on a blockchain through the use of a smart contract. In a second step, the tokens are linked to the asset.
Crucially, tokenization ought to give the holders of the tokens an enforceable claim to the underlying asset. How this is achieved depends on the assets that are to be represented by the tokens, i.e. whether (i) the transfer of the token also transfers possession and possibly ownership of the underlying asset or (ii) the transfer of the token transfers a claim against the issuer of the token. We refer to the first model as an possessory link and the second as a contractual link.
Tokenization through a possessory link
The model of tokenization through a possessory link is suitable both for physical assets such as gold, real estate shares and works of art and for non-physical assets such as shares, bonds and fund units that are securitized in a physical global certificate and require a transfer in accordance with property law principles. Under this model, ownership of the respective assets is conveyed to the token holder by a third party (e.g., the issuer of the token or a custodian), whereby ownership of the underlying asset can also be transferred to the token holder.
Tokenization through ownership link therefore requires that ownership of the underlying asset is conveyed by a person. The following requirements must be met to implement the model:
Contractual link
The tokenization model by contractual link is suitable for the tokenization of claims against an issuer, such as corporate bonds, cash, profit participation rights, loans or other debt instruments. The model can be used if the token is to represent a claim against the issuer of the token itself. The assertion of the claim is linked to possession of the token. This is achieved through corresponding clauses in the contractual basis that regulate the legal relationship between the issuer and the token holder.
Although tokenization by contractual link requires the use of smart contracts to create and manage the associated tokens, the smart contracts themselves do not establish the legal relationship between the issuer and the token holder. Instead, the actual contract is created by the subscribers agreeing to a subscription agreement during the subscription process, which makes the terms and conditions associated with the tokens legally binding. If desired, the conditions can be embedded in the smart contract in readable form so that subsequent token holders can become aware of the conditions.
